Compensation for Exchange Loss to Import Agent Allowed as Business Expenditure under Section 37

The Madras High Court in Assab Sripad Steels Private Limited Vs CIT -1 (Madras High Court) has clarified an important issue relating to the deductibility of compensation paid to an import agent for foreign exchange fluctuation losses. The Court held that such compensation, when arising out of a commercial arrangement and crystallised liability, is allowable as a business deduction under Section 37 of the Income Tax Act 1961.

This decision is particularly relevant for entities engaging in imports through intermediaries and facing contractual claims due to delayed payments and currency volatility.

Background of the Dispute

For the assessment year 2004-05, the assessee company filed its return of income on 30.10.2004 declaring an income of Rs.92,91,066/-. During scrutiny, the Assessing Officer disallowed total expenditure of Rs.81,63,659/- under three heads. In the present appeal before the High Court, only two of those disallowances were in dispute:

  1. Rs.45,67,071/- – alleged compensation paid to M/s. Sterling Matchem Trade (P) Ltd. (SMTPL) towards loss suffered by SMTPL due to fluctuations in foreign exchange rates arising from delay in payment by the assessee.
  2. Rs.35,00,000/- – compensation paid for premature termination of an agreement dated 15.06.2000 entered into between the assessee and SMTPL.

The Commissioner of Income Tax (Appeals)-III, Chennai allowed the assessee’s appeal in full. The Department’s appeal before the Income Tax Appellate Tribunal (“ITAT”), ‘C’ Bench, Chennai, resulted in partial relief – the Tribunal sustained the deletion of Rs.35,00,000/- (termination compensation) but restored the disallowance of Rs.45,67,071/- relating to exchange loss compensation.

Aggrieved by this partial reversal, the assessee approached the Madras High Court under Section 260A of the Income Tax Act 1961.

Core Issue Before the High Court

The central controversy was whether the amount of Rs.45,67,071/-, paid by the assessee to SMTPL as compensation for losses due to foreign exchange fluctuation (arising from delays in payment beyond the agreed credit period), qualifies as a deductible business expenditure under Section 37.

The Department’s stand was that:

  • The agreement dated 15.06.2000 did not expressly stipulate any obligation on the assessee to compensate SMTPL for forex fluctuation losses; and
  • Consequently, such payment was not contractually enforceable and hence not allowable under Section 37.

The assessee, on the other hand, contended that:

  • The liability arose under the commercial arrangement and terms of the agreement.
  • The payment was made out of commercial expediency, in the course of and for the purpose of business.
  • The obligation was crystallised by a Board decision on 18.03.2004 and hence was an accrued liability for the relevant year.

Substantial Questions of Law

The High Court admitted the appeal and considered the following substantial questions of law:

  1. Whether the Tribunal was correct in interpreting Section 37 in a manner that effectively restricts the allowance of business losses as business expenditure?
  2. In the absence of any express prohibition against payment of compensation for exchange loss on advance termination of contract, whether upholding disallowance of such compensation was legally sustainable?
  3. Whether the Tribunal erred in disallowing expenditure supported by the contractual understanding between the parties at the time of early termination of the agreement?
  4. Whether the Tribunal failed to appreciate that a business liability could arise on a quasi-contractual basis and, on such termination, the liability should be allowed as a business expenditure under the Income Tax Act 1961?

Factual Matrix Relating to the Agreement

The assessee had entered into an agreement dated 15.06.2000 with SMTPL under which:

  • SMTPL was to import specified materials on its own account but on behalf of the assessee.
  • SMTPL would incur customs duty, port charges and other handling charges and arrange for transportation and storage.
  • The assessee would purchase the goods from SMTPL, with an agreed credit period of six months from the date of dispatch of material.
  • SMTPL was to remit foreign exchange to the foreign supplier within six months from the date of dispatch.

Over time, the assessee delayed payment considerably in a number of cases, sometimes beyond one year from the agreed credit period. Because of this delay, SMTPL had to remit foreign exchange at adverse exchange rates, suffering significant forex losses. SMTPL claimed compensation from the assessee for these losses.

Notes to Accounts and Crystallisation of Liability

The assessee’s notes to accounts, forming the basis for the claim of deduction of Rs.45,67,071/-, recorded the following: